Gold's QE3 Anomaly
Gold's biggest psychological overhang this year has been the fate of the Fed's third quantitative-easing campaign. Gold futures traders hang on every word of Fed officials, extrapolating them into a timeline for ending QE3. This consuming obsession fueled unprecedented selling that spawned a stunning gold anomaly. But as QE3's nature becomes more apparent, gold is due for a massive mean reversion higher.
It probably already started. Just this week, the Fed Chairman Ben Bernanke aggressively backtracked on his recent timeline for slowing and then ending QE3! At a speech in Massachusetts, he said the Fed is failing on both sides of its dual mandate with unemployment too high and inflation too low. Therefore the Fed ought to keep maintaining zero interest rates and buying bonds until both areas greatly improve.
Futures traders, who face huge risks with their wildly-outlying record gold short positions, responded by flooding back into gold. They have to be scratching their heads though, as Bernanke's sharp turn-one-eight makes the whole Fed look schizophrenic. Just 3 weeks earlier, at the Federal Open Market Committee's latest June meeting, the Fed commissioned Bernanke to warn traders QE3 would soon end!
And that is nothing new, QE3-ending-sooner-rather-than-later fears first flared up in early January when the minutes were released for the FOMC's December meeting. Despite that being the landmark one where the FOMC nearly voted unanimously to radically expand QE3, there was plenty of internal dissent even then. Ever since, gold traders have had to divine which Fed faction is gaining the upper hand.
So 2013 gold price action has devolved into a ridiculous circus of Fed hysteria. This centers around two events, Fed meetings and their minutes. The FOMC that manipulates interest rates and monetizes debt meets 8 times a year, or about once every 6 weeks. And 3 weeks after each meeting, its minutes are released. These events often spark big gold volatility, even though the FOMC rarely changes anything.
After well over a decade intensely studying gold's fundamental, technical, and sentimental dynamics, I find myself in the irritating position of having to become a Fed expert. Now instead of interesting things like global supply and demand, gross Fed market manipulations are moving gold prices. So I know far more about the goofy Fed and its ruling officials than anyone should, which is not a boast but a lament.
But I think traders, especially in the futures realm, are missing the forest for the trees. They are so worried about what Bernanke had for breakfast that they've totally lost sight of the big picture. It doesn't matter one bit what the Fed says, but what the Fed does. And throughout this entire raucous 2013 "debate" about what the FOMC is planning for QE3, it has continued to aggressively monetize debt without respite.
When normal traders buy bonds, existing cash flows from the buyer to the seller. But when central banks like the Fed buy bonds, they first create the necessary money out of thin air. This literally turns debt into money! And of course a growing money supply is highly inflationary, whether its impact is immediately apparent or not. Relatively more dollars chasing relatively less goods and services guarantees higher prices!
So instead of gaming what the Fed might do with QE3 months in the future, gold traders need to be looking at what the Fed is doing today. And for the entire 6-month span since early January where gold futures traders pathologically feared QE3 vanishing, this massive inflationary campaign has continued steaming full speed ahead. All the Fedspeak is misdirection, the Fed hasn't slowed QE3 by a single dollar.
While the Fed theatrically wrings its hands about the risks of injecting such vast monetary inflation into the economy, its balance sheet just relentlessly keeps on growing. That is where the bonds it buys with freshly-conjured money end up. So far in 2013 alone, the Fed's balance sheet has soared by a truly frightening 19.7%! That is absolute, not annualized. QE3 is unleashing astounding amounts of dollars.
This first chart is exceedingly important for all speculators and investors to understand. It summarizes the epic monetary experiment of quantitative easing since late 2008. That's when the FOMC drove its primary tool of the federal-funds rate to zero. Ever since that crazy zero-interest-rate policy (ZIRP) was implemented and immediately failed, the Fed has relied on unconventional and highly-risky monetizing.
The Fed has been buying US Treasuries, mortgage-backed securities, and agency (GSE) debt over the past 5 years or so. These categories are rendered below in red, yellow, and green respectively. They are stacked within the total Fed balance sheet, shown in orange. So the red Treasury band doesn't start at zero, but right at the top of the yellow MBS band. Pay close attention to what has happened in 2013.
Basically since November 2008, the Federal Open Market Committee has launched a long series of bond-monetization campaigns. If you are interested in the events surrounding each escalation, I've explained them in depth in past essays on quantitative easing. But we're not here to get lost in the trees of detail like the gold futures traders, we need to keep the strategic overview of the whole forest in focus.
Fed officials trying to jawbone markets into believing QE is temporary is nothing new. Ever since early 2009, they have tried hard to keep inflation expectations firmly under control. There is nothing the Fed fears more than inflation expectations, people beginning to believe prices are going to rise relentlessly and rapidly due to money-supply expansion. This mindset dramatically alters people's financial behavior.
So each time QE is escalated, there are always promises it will be short-lived and soon unwound to restore financial markets to normal non-manipulated functioning. I've carefully studied every single FOMC meeting and minutes since 2008, in real-time as they happened. And without fail, every time the Fed adds additional bond purchases it goes to great pains to set expectations that they won't last for long.
Yet what is now known as QE1 mushroomed dramatically into the QE1 expansion (or QE1X). Then QE2 came along, which was soon expanded as well. Then the Fed tried to stop monetizing through what was called Operation Twist, rolling already-owned short-term Treasuries into new longer-term ones. And then QE3 was recently born then quickly expanded, the first open-ended monetization with no stated limit.
Throughout this entire 4.6-year span, which has now lasted for so long it is secular, the Fed's balance sheet continued to grow on balance. Despite endless reassurances that QE would soon be unwound, it has just kept growing and growing and growing. Actions speak louder than words. Fed officials have no idea how long QE will run, they never have. They are hostage to financial markets totally addicted to it.
Despite all of 2013's QE3-tapering talk, the Fed's balance sheet, the Treasuries it has monetized, and the mortgage-backed securities it has bought have all reached nosebleed record highs in just the past week. At an astounding $3445b, the Fed's balance sheet has skyrocketed 288.2% higher since August 2008 before that once-in-a-century stock panic spooked the Fed itself into freaking out. It's nearly quadrupled!
As of last week, a record $1943b of that or 56% was in US Treasuries. Wall Street, which loves easy money, constantly claims QE isn't inflationary because banks aren't lending all the money created. That may be true in MBSs, but it sure isn't in Treasuries. Because of the Obama Administration's wildly unprecedented deficits and massive debt growth, the US Treasury immediately spends every dollar it gets.
The Fed held Treasuries before the stock panic as well, but at far-smaller levels. The total impact of QE so far in Treasury terms is injecting an additional $1463b of newly-created money into the system that didn't exist in August 2008. This is incredible inflation already baked in, regardless of the carefully-tailored inflation-is-dead story the intentionally-lowballed government inflation statistics are designed to tell.
Once again the Fed's balance sheet has soared by 19.7% year-to-date, and half of that was in newly-monetized US Treasuries. Without the Fed creating money out of thin air to monetize Washington's gross overspending and keep bond yields artificially low, the US government would implode under the weight of crushing interest payments. Bernanke is the primary enabler of big government spending!
With all this inflation, newly-conjured money immediately spent by the federal government, gold ought to be soaring in 2013. But instead it has been utterly crushed, plunging at an unprecedented speed and magnitude. Two factors drove much of the selling, hyper-leveraged gold futures traders getting trapped in disastrous forced-liquidation scenarios and stock traders dumping the GLD gold ETF to chase general stocks.
But underlying this all is the irrational fear QE3 is going to end soon. Why does anyone actually believe that given the Fed's long track record of refusing to shrink its ballooning and dangerously-bloated balance sheet? Gold traders need to ignore what the Fed says, and focus on what it is doing. But since they've foolishly done the opposite in 2013, gold has suffered an epic anomaly that will violently reverse.
For millennia monetary inflation has been extraordinarily bullish for gold for obvious reasons. While paper money supplies ramp up at double-digit rates, gold mining only adds about 1% to the world gold supply each year. So there is relatively more money available to compete for relatively less gold, driving up its price. And conjuring up new money ex nihilo is the purest and most direct form of inflation there is.
So gold should have soared during QE3, there is no doubt! I predicted it would soon after QE3's birth, and I stand by that forecast despite 2013's carnage. Before QE3 fully runs its course, gold will almost certainly be much higher than the $1733 it was at the day before QE3's introduction. And from today's epically-oversold gold prices, that means we are in store for one hell of an upleg. It should be this bull's biggest.
To help understand why, I superimposed the gold price over the outline of the same Fed-balance-sheet data from the first chart. Gold soared during QE1, powered higher during QE2, and will do the same in QE3 once this crazy psychological anomaly that has so depressed it this year inevitably passes. Market extremes driven solely by emotions never last for long, fundamentals soon forcefully reassert themselves.
During QE1, gold soared 50.8% higher over a span where the Fed's balance sheet only grew by 6.8%. Why? Traders were focused on the truth of bond monetization being highly inflationary, and bought gold accordingly. During QE2, gold powered 24.7% higher while the Fed's balance sheet ballooned by 23.1%. Again this was the normal, logical, and expected gold reaction to a flood of new money pouring in.
Yet so far during QE3, gold has plunged 27.8% despite the Fed's balance sheet already surging 22.8%! This doesn't make any sense at all. The Fed has added $639b of new dollars to the system that had never existed before September 2012, yet gold has lost over a quarter of its market value. And it's not like gold was overbought when QE3 was born, it had just spent 13 months in a healthy high consolidation.
Wall Street, which has always hated gold, argues that the reason gold has plunged is because QE3 is not inflationary. That is nonsense, monetizing debt always is by definition. Gold has fallen because stock markets surging to new cyclical-bull highs sucked capital and interest away from classic alternative investments like the yellow metal, and hyper-leveraged futures traders got caught on the wrong side.
But at some point this excessive short-term gold selling has to dry up. There is only so much gold held in trust by GLD, and only so many shareholders interested in selling who haven't already sold. At some point only strong hands, true believers in gold's bullish global supply and demand fundamentals, remain. And there are only so many futures traders brazenly willing to short gold low after its biggest plunge in modern history.
As these enormous and unprecedented gold headwinds exhaust themselves, which is absolutely inevitable since they are far too large to be sustainable, gold will recover out of this crazy selling anomaly that happened to coincide with QE3. And as gold rallies, the fundamental inflationary impact of QE3 will return to focus like it had within QE1 and QE2. And gold will soar in a likely-violent mean reversion.
QE3 actually has the potential to kindle far-greater inflation expectations and eventually fears than QE1 and QE2. Why? QE3 is open-ended. The Fed has put itself in a dangerous box by not defining the size of QE3 up front like it did with QE1 and QE2. As we've recently seen, every time the Fed attempts to prepare traders for the eventual end of QE3 the stock markets and bond markets react quite hostilely.
As I discussed in last week's essay on gold and long rates, Ben Bernanke merely laying out a best-case good-economic-data-dependent scenario for tapering and ending QE3 triggered wild market disruptions. Yields on benchmark 10-year US Treasury Notes soared in their biggest and fastest rally over such a short span in at least a half-century! This catapulted mortgage rates higher, tightly tying the Fed's hands.
Ironically futures traders hammered gold on Bernanke's QE3-tapering timeline too, which blew my mind. Bernanke's best-case scenario had QE3 tapering starting in October after being formally announced at the FOMC's September meeting. And QE3 would fully end by the middle of next year. If you run the simple math on its monthly purchases, and assume an even taper pace, the results are highly inflationary.
I explained all this in depth in our new monthly newsletter, but basically Bernanke's best-case scenario would still double QE3's total monetizations from here! As of the end of June, the monthly QE3 bond purchases were running $630b total. If Bernanke's timeline plays out, that will double to the order of $1250b by next summer (including the tapering)! $1250b dwarfs QE2's $900b, where gold gained 24.7%!
And I suspect QE3 won't end anywhere close to next summer as Bernanke had hoped, for a couple reasons. First, the FOMC's primary goal for QE3 is to artificially boost bond prices to artificially drive mortgage rates lower. Housing is absolutely critical to jobs growth in the US economy. The Fed can't and won't exit if heavy bond selling front running this biggest and dominant buyer leaving catapults mortgage rates.
Second, at its current wildly-unprecedented debt levels driven by Obama's outlying record deficit spending, the US government can no longer afford to pay normal non-manipulated interest rates on its vast pile of debt. A return to pre-QE interest rates would sink the US government, interest payments ballooning to absorb nearly all discretionary spending. Obama has locked the Fed into monetizing forever, it's tragic.
Sooner or later even gold futures traders will figure this out. They will stop trading on pure emotion and start looking to the fundamentals of gold and monetary inflation again. QE3 will still at least double if the Fed actually has the courage to slow and stop it, and will grow much larger than that if it doesn't. We are looking at a best-case $4060b Fed balance sheet next summer, and worst case with no tapering much higher.
All this new money has to flow somewhere, there is no option. It will bid up general price levels as the US government rapidly spends it. And as speculators and investors are forced to pay more for the goods and services they buy, gold will reappear on their radars. Add big inflation-driven gold investment demand to today's radically-oversold gold price and apocalyptically-bearish sentiment, and gold is due to soar.
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The bottom line is QE3's huge debt-monetization inflation will ultimately prove wildly bullish for gold. If Bernanke's best-case tapering timeline proves true, QE3 will still double in size from here. And as gold's vicious headwinds driven by the mass exodus from GLD and futures forced liquidations abate, the focus will return to the fundamental inflationary impact of quantitative easing. Reason will prevail as fear vanishes.
Gold prices climbed dramatically in both QE1 and QE2, and QE3 is going to be much bigger than QE2 and probably approach QE1's massiveness as the Fed vacillates. So there is a high probability gold will rally considerably over QE3's entire span. And since it has lost so much ground in 2013's epic sentiment storm, that means the mean reversion higher from here should drive the biggest upleg of its secular bull.
Jul 12, 2013
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